THE idea of progress has led to a belief that governments should be judged on the basis of how effective they have been in changing past policies. It is the opposite of the conservative adage that if there is no strong reason to change there is a strong reason not to change. From this perspective of progressivism, the record of economic and development policy reform of this government has been a very mixed one. Some good and sensible things were done; at least one disastrously foolish thing was thrust upon the public and there was a persistent tendency to announce grand targets without really working out whether they were feasible.

Take first the sensible changes like the implementation of the General Sales Tax (GST), the passing of the Insolvency and Bankruptcy Code (IBC) and the depoliticization of interest rate policy.

The GST has been in the works for well over a decade; the present government can clam credit for bringing the negotiations to a closure. We now have a single sales tax structure in the country and a cooperative federal system for managing it. However the implementation could have been better planned and managed with a phased introduction of online reporting and a simpler tax structure.

 

A certain lack of familiarity with the workings of the Indian economy are evident in the attempt to introduce a very sophisticated online invoice matching system in a country where the modes of transaction and payments range from primitive currency based transactions in large parts of the economy to barely formal systems elsewhere. It also showed ignorance about the state of communications infrastructure. How for instance did they expect a small dealer in some remote small town to upload hundreds and thousands of invoices onto the Internet-based tax network? It is no accident that this part of the GST reform had to be modified and diluted soon after the launch.

The implementation of the Insolvency and Bankruptcy Code reflects another weakness of the policy planning process, the belief that there is some magic bullet which will put an end to some long-standing and big problem. Hopes were voiced that this code would help to resolve the problem of non-performing assets of banks. It has done no such thing and the lenders have been forced to take huge haircuts. Moreover, the code failed to anticipate the cleverness of Indian businessmen, many of whom ran rings around it, and the complexities of our legal system. Hence the legally mandated 270 day deadline has been breached in most cases and only three of the 12 cases initially referred by the RBI have been resolved.

 

The depoliticization of interest rate policy with the establishment of a Monetary Policy Committee (MPC) was a welcome move and seems to have worked well with detailed minutes of the views of each member being made available to the public. The chosen independent members commanded the respect of their professional peers and have no obvious political affiliations. But has the government really accepted the logic of this reform whose intention was to distance the political executive from the decisions which had to be taken for inflation management? In recent months we have seen many attempts to pressurize the MPC by high functionaries of the Ministry of Finance.

We see the same reluctance to accept the idea of autonomy in the recent spat between the Ministry of Finance and the Reserve Bank of India. This has led to the resignation of the Governor, Urjit Patel, ostensibly for personal reasons, but quite clearly as a reaction to the public assertion of ministerial control directly through its own representatives and the political affiliates appointed to the board. This has happened only twice before in the 83 year old history of the RBI and is an indication of how aggressive the government has been in its assertion of power. The appointment of a bureaucrat, close to the politicians presently in power in Delhi, who oversaw the implementation of a badly conceived and politically inspired demonetization exercise, suggests that fears about the erosion of RBI autonomy are justified.

Central banks exercise functions, like currency issue and regulatory oversight, that are derived from the sovereign powers of government. The case for central bank autonomy rests on the belief that direct political control over money supply and monetary policy may be excessively driven by short-term political considerations and this could compromise financial stability. A further complication in India arises from the possibility that the government, which owns 70 per cent of the banking assets and borrows 70 to 80 per cent of the fungible financial savings of households, will not be objective as a regulator.

The solvency of banking institutions and the predictability of interest rates and exchange rates is particularly essential for the stability of financial markets. The perception of savers and investors, particularly those based abroad, about this dimension of economic stability does depend on the degree of autonomy of the central bank. Hence the recent moves to increase government control over the RBI go against the long-term aim of opening up of local capital markets. Was this dimension considered or was the spat largely an outcome of the unwillingness of the Ministry Finance to let go of control?

The one lesson that emerges from this current controversy about Finance Ministry-RBI relations is that autonomy and accountability must be designed together as was done in the case of the MPC where responsibility for interest rate policy was delegated to the RBI, along with the responsibility of explaining failures to adhere to the agreed inflation targets.

 

So much for the sensible things that the government has done. Now for perhaps the most foolish policy initiative in recent times – the demonetization of 500 and 1000 rupee notes from the midnight of 8 November 2016. Initially this drastic measure was put forward as a way of getting at hoards of black money. This reflected serious ignorance about how the black economy functions. Most of the illegal wealth generated through tax evasion, transgression of other laws, and criminal activity is not held in cash but in the form of income generating assets like benami property or salted away abroad in tax havens.

The very fact that practically all the demonetized cash that was outstanding on 8 November 2016 has been deposited in bank accounts shows how seriously misconceived the initial objective was. Later justifications like the purported gains in digitization of payments (increasingly under question) and tax compliance cannot justify such a hugely disruptive measure. There are better and more intelligent ways for attaining these objectives.

 

Demonetization was a badly conceived and inefficiently implemented measure that cost the economy dearly. There was a case for removing the highest value notes from circulation in order to put grit under the wheels of the black economy and thus slow it down. But if this was the intention why was the 2000 rupee note introduced as a substitute?

The government should have anticipated that an economy in which most enterprises and households conducted their legitimate transactions in cash would be seriously inconvenienced by a measure directed at a small proportion of the population. If it had to be done, the 500 rupee note could have been left alone and the 1000 rupee note could have been gradually withdrawn as it came into the banking system. The demonetization could have been done when the value of the outstanding 1000 rupee notes and had come down to 10-20 per cent of currency outstanding. This would have avoided the massive disruption that followed the 8 November announcement, which demonetized 86 per cent of the currency outstanding.

 

Now from the sensible and foolish things to the initiatives that lie in between these two extremes – the frequent announcement of schemes with ambitious time bound targets but with little analysis or understanding of the challenge of implementation. One example of this proclivity for targeting without planning is the promise that by 2022 every Indian will have a pucca house with 24/7 electricity and running water with little analysis of what this will require by way of urban policy, particularly on land rights, construction materials and capacity and finances at the state, municipal/panchayat and household level. The announcement of the goal of installing 175gw of renewable energy by 2022 is another case of announcing first and struggling to work out the implications later.

There is another important dimension to this tendency of the central government, more particularly its head, to announce schemes, which have to be implemented largely by the states without involving them in the design, perhaps because there is no design when the announcement is made. This seriously compromises the prospects of implementation and sometimes leads to public spats with states run by opposition parties.

The tendency to think in terms of schemes with simple targets also neglects the interconnectedness of problems and solutions. Take for instance the government’s approach to the problems of non-banking financial companies (NBFCs), the financing of medium small and micro enterprises (MSMEs) and the formalization of payments for business transactions. These three problems are interlinked as much of the activity of NBFCs is linked to the financing of MSMEs and part of the problem of financing MSMEs is that many of them function on the basis of cash transactions, partly to stay outside the tax net and partly because of difficulties in accessing formal banking channels. Hence all three challenges need to be tackled in a coordinated fashion.

The same case for a more integrated approach is evident in other sectors – for instance the link between improved local water supply and the attendance of village girls in school or clean water, the reduction in diarrhoea diseases and better nutrition status of children. This absence of integration is evident in the single-minded obsession about building toilets, many of which are now unused because of a lack of water.

 

Yet another area that shows the weakness of fragmented policy making is the government’s support for urban development. Urban governance, municipal finance and the operation of urban land markets are deeply intertwined. Yet the government’s approach to them has been very piecemeal.

On urban governance we have piecemeal schemes that focus largely on administrative reforms without addressing the core issues of empowering municipalities and mayors and decentralizing financial authority as envisaged in the 73rd and 74th amendment of the Constitution. Much of this refusal to decentralize authority is linked to the nexus between state level politicians and land mafias in the ruthless exploitation of rising land values. The response is to run away from the problem and rely on grand projects like urban metros, grand sounding schemes like the smart cities project or the incentives for housing loans.

This refusal to let go of political control is also evident in the difficulties faced in resolving the problem of non-performing assets in commercial banks. There is widespread political interference in investment directions to public sector banks with the intention of serving some private business interests rather than that of depositors or policyholders. Nationalization of banks and insurance companies was supposed to correct the diversion of resources by bank owners for the needs of their other businesses. We have ended up with that same syndrome but now with politicians actively involved in this distortion, which accounts for much of the problem of bank NPAs.

 

Another reason the problem of NPAs has arisen is the move towards public-private partnership in infrastructure that started in the early ’90s. Little consideration was given to the lack of a long-term debt financing market, which has to be the basis for the commercial financing of infrastructure. The few term-financing institutions that we had were run down and the burden transferred to commercial banks whose loan assessment systems were not designed for this. Under political pressure bank lending for infrastructure zoomed. Here was an instance of the government abdicating its responsibility perhaps because fiscal resources were under pressure from the demands of populist programmes and from fiscal conservatism focused on the budget deficit.

A government that focused on a long-term view would have recognized that public expenditure on infrastructure should rise more than proportionately to GDP growth. It should have also anticipated that demands for better education, health care and social security require more than proportionate growth in social expenditure. Hence, raising tax buoyancy should have been the primary goal rather than short-term fiscal stabilization.

Financial sector reform cannot proceed on the basis of piecemeal firefighting schemes. The most important requirement is to work out an ownership structure consistent with political realities. Private ownership of banks can work if it is independent of the linked corporate borrowers. It would be difficult to find a private entity in India that has the capital base to provide this. Foreign institutional investors largely own the successful private banks in India. Hence denationalization of government owned banks and insurance companies is not the answer. The answer lies in distancing these companies from direct governmental control.

 

These weaknesses in the public policy process are not unique to this government. Many go back to previous administrations. Hence we need a more systemic view of these weaknesses and look for a reform of the reform process.

First, there is a surprising ignorance amongst the political leadership and bureaucracy about how the Indian economy functions. This must be attributed to the excessive centralization of decision making and limited consultation with knowledgeable outsiders and people in the political system and the bureaucracy more aware of ground realities. Greater consultation, transparency and dialogue in the policy formulation process would help.

Second, the government must recognize that the private sector will try and circumvent interventions that affect their profits. Hence in designing policy it should anticipate loopholes. The record shows that government draftsmen are not good at this. Perhaps the answer lies in the equivalent of ‘ethical hackers’ who know how to subvert systems and can work out potential vulnerabilities, which policy draftsmen can take into account.

Third, the piecemeal approach to reform prevents the recognition of interlinkages that could prevent the change from delivering anticipated results but which can also provide creative indirect ways of attaining the desired goals. For instance, giving priority to formalization of business payments may help to resolve MSME financing and NBFC challenges.

 

Fourth, the government must recognize that there must be a firewall between its status as an owner and its responsibilities as a policy maker. Direct political control over commercial entities owned by central or state governments must give way either to privatization or if that is not feasible or desirable, in creating distance through an autonomously managed holding company.

Fifth, the design of policy to create autonomous institutions must include clear accountability procedures which the autonomous institution and the government must both respect.

Sixth, no scheme or programme or target should be announced without it being embedded in a prior articulated sectoral strategy.

Seven such sectoral strategies must be designed in consultation with all implementing entities, particularly the states that are constitutionally responsible for almost every major area of sectoral development other than telecommunications and the railways.

Finally, and most importantly, the government must have and share with the country a long-term vision of economic and strategic independence. No country has become a global economic power without building indigenous entrepreneurial and technological capacity. No country has become a global political power without building an indigenous armament and related research capacity. Every policy, scheme or programme that the government announces must be consistent with this vision.